Coronavirus and Oil Shock Market Update

March 09, 2020

Market Update – 3/9/2020

Fear over the impacts of coronavirus, a sharp drop in oil prices, and government bond interest rates hitting historic lows are shaking markets. What is happening, and what does it mean for you and your investments?

The coronavirus (COVID-19) outbreak began in China right before Chinese New Year. The country acted quickly and essentially shut down for over three weeks. People are just now starting to return to work. While this helped to slow the transmission of the virus, it continues its spread throughout the world. There are now over 113,000 confirmed cases of coronavirus globally. There is still a lot we don’t know about transmission rates, how many people are actually infected, how deadly the virus really is, and what the economic impacts will be. We believe that this uncertainty is part of the reason that markets are moving so erratically day by day.

Some people compare coronavirus to influenza (“the flu”). Both are infectious respiratory illnesses, so let’s look at the flu. The CDC estimates that in the U.S. between October 1, 2019 and February 29, 2020, there have been 34 to 49 million flu illnesses (infecting roughly 13% of Americans) and 20,000 and 52,000 deaths – a fatality rate of about 0.1% of those infected. We don’t know how many people will be infected with coronavirus or how deadly COVID-19 will be. Despite early fatality estimates as high as 3.4% of those infected, more recent estimates from South Korea and China put COVID-19’s fatality rate at 0.6%, still substantially higher than the normal flu. Fatalities have been seen primarily among elderly people with serious existing medical issues. The coronavirus is not something we should panic about, but it is something we should take seriously – especially if we are in that higher risk group. We expect that confirmed cases will continue to rise, but the level of impact is still unknown.

What about the financial impacts? One of the great benefits of owning stocks in a diversified portfolio is that every day, millions of people around the world are getting up and going to work to try to make money for the companies you own. With coronavirus disruptions, if less people are going to work and your companies’ sales decline, their values will go down - temporarily. Pre-coronavirus, the 500 largest companies making up the S&P 500 were valued at an average of about 17 times their annual earnings. So, if we paid 17 times earnings and now a year’s worth of earnings were erased due to this slowdown, that would translate to a 5.88% (1/17) reduction in your company’s value. As we write this (March 9, 2020) the US stock market is down approximately 18% from its recent high - so just over three years’ worth of earnings.

Markets are taking an additional hit today because of a feud over oil between Russia and Saudi Arabia. First, some background:

According to the US Energy Information Administration, the #1 producer of oil in the world is the US. #2 is Saudi Arabia. #3 is Russia. The US used to be #3 as recently as 2014.

The government of Saudi Arabia has a primarily state-owned oil company Saudi-Aramco with history dating back to the 1930’s. Aramco was the largest company in the world, valued at $1.88 trillion, in December of 2019 when the government of Saudi Arabia sold a small percentage of the company to the public in the largest initial public offering (IPO) ever. Saudi Arabia is part of OPEC (the Organization of the Petroleum Exporting Countries), an intergovernmental organization (let’s get real – it’s a cartel) of 14 nations created in 1960 with Iran, Saudi Arabia, Iraq, Kuwait, Venezuela, and now others as members. Neither Russia nor the U.S. are OPEC members, although Russia attends meetings as an observer and usually cooperates with OPEC. Russia is not a member because oil and gas revenues make up over 50% of Russia’s federal budget revenue, so it’s a key strategic industry for them – not one they would cede control of to any external organization.

Oil prices are driven by supply (from the countries described above) and demand. If airplanes stop flying, cruise ships sit at the dock, people stop driving to work, and some factories are shut down, oil demand will drop quickly. If supply remains constant, prices drop because there are less people to buy the oil that’s produced. That’s where OPEC typically comes in. If the OPEC members all agree to cut their production at the same time, supply drops along with demand and prices remain stable. That’s usually what happens. But over the weekend, Russia refused to join OPEC countries in cutting production. Saudi Arabia retaliated by cutting prices and increasing production and oil prices crashed. Saudi Arabia can do that because their cost to produce oil is extremely low. It’s an exaggeration to say they can stick a straw in the ground, but you get the idea. Russia’s cost is higher than the Saudis, but is still relatively low. The US has the highest costs of production. Fracking is what pushed us from the #3 producer to #1 so quickly, but fracking is expensive.

There are positive and negatives here. Of the 30 stocks that make up the US Dow Jones Industrial Average, two are oil companies (Exxon and Chevron). Oil and gas supports 10.3 million jobs in the US and makes up 8% of our economy. Market prices that are below US companies’ cost of production mean values of these companies drop, they lay off workers, and their ability to pay their debts could be called into question. So, that’s obviously bad. For countries whose economies are primarily dependent on oil like Iran and Venzuela, it’s much worse. On the positive side, as prices at the pump drop, lower costs act like a tax cut to the US economy and stimulate growth. Where will it go from here? It is possible that Russia and OPEC come back to the table and negotiate a truce. It’s also possible that things drag on. The stock market will adjust prices to reflect its forward-looking estimates on an ongoing basis.

So, how will this impact your investments? The possibility that we are entering a global recession has now become much more probable (though not a certainty). We have seen losses in stocks in the short-term and this could continue. On the other hand, we could see new infections of coronavirus diminish, we could see stimulus from the Federal Reserve, and stock prices could begin to bounce back quickly. Events like a coronavirus outbreak are impossible to predict yet we know they occur. Because of that, we keep money that will be needed over the next 3-5 years or more in a safe place like bonds, to enable our clients to withstand these short-term dips. With interest rates declining, bonds are performing well and are up over 5% year-to-date. This gives us the flexibility to draw from the safe funds and allow the stock investments to recover from short term swings in the market. Events like this also provide a potential buying opportunity for investors who have funds in cash or safe investments to buy quality companies with strong long-term prospects at lower prices. We are closely monitoring the situation and will make adjustments to your portfolio as we receive more information. In the meantime, feel free to call us if you’d like to discuss your situation. Thank you again for your continued trust and confidence.